Cheap funds beat expensive ones – here’s the proof

When I interviewed Anthony Bolton earlier this week (you can read the whole thing in the subscribe to MoneyWeek magazine, out on Friday), we argued about the fees on the China fund he manages for Fidelity. I think 1.5% plus a performance fee is just too much. He doesn’t. You have to pay to get good performance, he said. Then he asked me if I have any evidence that low-fee funds perform better than high-fee funds. I didn’t.

We know, of course, that assuming the same performance, investors in low-fee funds do better than those in high-fee funds. But actual research showing that you can make the case that, in general, the lower the fee the better the performance? I couldn’t cite anything.

My argument was just that as you can’t know what the performance will be until it is too late, you are best off investing in low-fee funds in the first place. If you can only know one thing, you might as well get that bit right.

So imagine my pleasure this week on opening another press release from start-up fund management company TCF which appears to suggest that there is at the very least a correlation between fees and performance.

TCF looked at the returns of the three IMA managed sectors by total expense ratio and then looked at the performance of the cheapest 25% and the most expensive 25% relative to the average performance of all the funds over three and five years. And guess what? “Lower costs are a very strong predictor of future returns – beating or meeting the returns from the higher cost peers in every case.”

Take the Active sector. Over three years, the sector average return was 6.16% and over 5 years, it has been 4.14%. The relevant numbers for the most expensive funds were 5.2% and 3.52%. And for the cheapest funds? 6.36% and 4.59%. That’s a difference of over 1% a year in both time periods.

It might not sound like much, but if you know anything about compound interest, you will know it adds up (if you aren’t sure about this, here’s a fascinating article on the subject John Stepek pointed out to me earlier this week).

So there you go – cost really does matter. But I think it is going to matter even more from here on. The conventional investment model (put cash in fund, leave it there, get 6-8% a year, retire) is broken and investors are beginning to catch on. They know we are in an era where wealth protection is the key and they know that charges are wealth destroyers or as TCF put it “a sure way to get nowhere fast.” I’m forwarding the research to Fidelity.